Cost Method of Accounting

Instructor: James Walsh

M.B.A. Veteran Business and Economics teacher at a number of community colleges and in the for profit sector.

The cost method is a conservative method of accounting for investments. We will explore when the cost method is used and show the journal entries for purchase, sale and changes in value.

What Is the Cost Method?

Florie Lanier is a billionaire investor. She is one of the Big Fish on an investing TV show where she can put her money into small businesses for an equity (ownership) stake. When an entrepreneur with a company called Fountain of Youth comes on the show pitching a potion that makes people look younger, Florie is all in. She makes an offer of $200,000 for a 15% stake in the business, and the entrepreneur accepts!

Florie knows it's risky to try to put a valuation on this business, since no one really knows if this potion will work on large numbers of people. Some people might even drink the potion and look older!

Florie takes the information back to her offices and gives it to her accountant to record. The accountant determines that they will use the cost method for recording the investment in the Fountain of Youth Company. The cost method mandates that the investment be booked at its historical cost, which in this case is $200,000. The $200,000 will appear as an asset on the balance sheet.

When to Use It?

The cost method is used when:

  • The investor has no substantial influence on the investee's policies. A quantitative measure of this is that the investor owns no more than 20% of the company.
  • The investment has no easily determinable fair value.

The journal entry to record the investment is straightforward:

Item debit credit
Investment in Fountain of Youth $200,000
Cash $200,000

Distributions from Profits

Fountain of Youth begins running TV ads promoting its potion, and sales are taking off. At the end of the year, Fountain of Youth has $100,000 in profits! As an investor, Florie has a claim on some of the profits. Since she owns 20% of the company, her share is $100,000 * 15% = $15,000.

When the check comes in, the accountant makes this entry:

Item debit credit
Cash $15,000
Income from investment - Fountain of Youth $15,000

This will increase Florie's income and cash flow on her financial statements. Dividends from stock investments are recognized in the same manner as dividend income.

Changes in Value

Florie is happy about receiving her check! She knows the value of the company is going up and wonders if some accounting changes are needed to reflect that. Her accountant tells her to forget it. Under the rules of accounting under the cost method, increases in fair market value are not recognized. The cost method is very conservative, meaning that only declines in the asset's fair market value (called impairment) are recognized in the financial statements. That occurs when fair market value falls below historical cost.

Unfortunately, things are starting to go sour for Fountain of Youth in their second year. Male customers start posting before and after photos after drinking the potion over a long period of time. The after photos showed sagging faces and hair falling out, and the customers are pretty angry about that! It's clear that Florie and her accountant have an impaired investment asset on their hands. They are going to have to write down the value of the investment by 50%, which they do as follows:

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